Putting One Vanguard Expense Ratio Increase under the Microscope

Earlier this year I noted the expense ratios of most of Vanguard's funds had edged uncharacteristically higher this year largely due to slumping assets. More details have come out in individual fund shareholder reports since then. I recently took a look at one of the family's largest and oldest funds, Vanguard Wellington VWELX to see if there were other factors besides asset depletion behind the increases.

Wellington's estimated annualized expenses for this year have increased to 0.37% from 0.29% in 2008 for the investor share class and to 0.23% in 2009 from 0.18% in 2008 for the fund's admiral share class. That's still among the lowest levies in the moderate- allocation category, but a 27% increase is a shock coming from the bastion of cheap investing.

In his letter to shareholders in Wellington fund's recent semiannual report, Vanguard president and CEO William McNabb first blames declining assets for the fund's expense increase. The math is simple: As assets fall, the fund's fixed expenses eat up a larger percentage of its assets. McNabb also notes Vanguard's contracts with subadvisors like Wellington Management often include breakpoints, or asset levels at which subadvisory fees tick down a notch or so. As assets increase, breakpoints work for you as the lower rates are applied to a bigger share of the kitty, lowering the overall expense ratio. When the kitty shrinks, however, less of the fund is eligible for the reduced fees, so expenses can go up. This happened at the Wellington fund, too, but it didn't have a major impact on overall fee levels. Overall, Wellington Management had a basic management fee of 0.07% for the six months ended May 31, 2009, which was up from 0.06% for the year ended Nov. 30, 2008, according its semiannual and annual reports.

Wellington's management fee, however, also is adjusted for performance. When the fund beats its benchmark--a blend of the S&P 500 and the Barclays Capital U.S. Credit A or Better Bond indexes--over the previous three-year period, Wellington's fee gets a boost. When it lags its benchmark, the fee shrinks. Though 2008 losses have taken a toll on the fund's three-year record ended May 31, 2009, it still did better than its benchmark, so it got the incentive bonus of 0.02% of assets, according to the fund's semiannual report.

But these factors don't completely explain the fee hike. Granted, assets shrank in 2008 and early 2009, but the fund was around the same size in late 2005 and early 2006 and managed to post better returns than its peers and benchmark. Yet the expense ratio for the investor class shares was 0.29% in 2005 and 0.30% 2006--both lower than it is now.

One reason for the difference is Vanguard gave Wellington Management a raise in 2007. When the fund's board of trustees renewed Wellington Management's contract at the end of that year it also agreed to adjust the subadvisor's fee schedule "to reflect the fair-market value of Wellington Management's services and the firm's need to maintain an expanded portfolio management team to manage a large fund in the balanced segment." We don't know the magnitude of the fee schedule changes because Vanguard no longer discloses the specifics of subadvisor management-fee breakpoints. But the firm's basic fee (before performance adjustments) did go from 0.04% of assets as of Nov. 30, 2006, to 0.05% of assets as of the same date in 2007 even though year-end total assets for the fund increased from nearly $46 billion to $50 billion, according to the fund's annual reports. And that basic fee hasn't dropped below 0.05% since then.

When my colleagues and I have asked in the past, Vanguard has maintained the family is still large enough to drive a hard bargain with subadvisors and strike attractive deals. (Getting 0.05% of assets of a multibillion dollar Vanguard fund can be much better than collecting 1% of a multimillion dollar fund of your own.) Still, I wonder if fee negotiations have gotten tougher in recent years and if at least some of the other more successful, long-tenured subadvisors have been able to negotiate pay raises. Either way, it's worth monitoring.